The value of the anchor customer in LNG projects
When Nigeria LNG started operations in 1999, it had become the LNG project that has gone to FID with the longest lead time from “first conception” to realization ever. There was a first idea for the project as early as 1974 – at least, that’s the earliest I know.
There is one project lagging even longer if you can call the Iranian LNG projects such a thing yet. Extremely long lead times for LNG projects seem to have become the norm rather than the exception.
There are many reasons bringing LNG projects to their knees before they make it into FID range. The gas reserve might be insufficient or the wrong kind of gas. It might prove too difficult to collect the gas in the first place or the environmental conditions where the gas is might prove challenging (let’s take Shtokman for evidence here).
At times, there are political reasons (Iran is a good example here) or civil movements make construction of an otherwise economically viable terminal impossible as countless examples in the US and other parts of the world can attest.
However, the most important reason for failure does not attract a lot of limelight. Its failure to assure that a creditworthy initial buyer gives the project the commercial foundation it needs to thrive on.
Project Genesis, Conception, and Development in LNG tend to be complex and arduous processes with lots of pitfalls. But no matter how crazy the flow charts look, they all respond to the same commercial constraints that other projects respond to.
First and all importantly – investors and lenders want to be sure that they will get their money back.
Then, they also want to be sure that they make some new money on top of their investment and this should be more than what they would potentially get in interest from a bank.
And lastly, they want to be sure that whatever their arrangement is – would withstand the test of time as we are looking at decades of operations.
The sums of money involved are from large to gargantuan so payback would have to occur over decades. This long payback period requires a buyer able and willing to cough up the stomach to take the commercial risk. This buyer – willing and creditworthy as he must be – as well as a contractual arrangement that would constrain him into a straightjacket of obligations limiting his abilities to react dynamically to changes in the market, is what makes the project overcome gravity and fly.
Over a period of often 20 years this is mighty hard to swallow for even the biggest and most stable companies in those nanosecond times.
But it is this first anchor customer that is critically necessary in order to convince lenders that their monies are safe even in case the market goes totally awry and that the buyer is strong enough to take the hit (any hit n fact).
This is usually expressed in a Take or Pay obligation cast in iron coupled with a pricing formula that would give the lenders confidence that no matter what the market does, there would always be sufficient cash flow for covering their installments.
Take or Pay in this respect means that the buyer will take all volumes that he has contracted for the duration of the contract or pay if he does not take the cargo. This ensures steady cash flow necessary to ensure the timely payback of debt accrued under a project finance deal plus a minimum return to potential investors.
This also means that if the market turns sour and the LNG cannot be sold for profit anymore the buyer would still buy the LNG at the agreed price in order to keep the project and hence the lenders safe.
If the buyer cannot offset the potential losses through optimization of his supply portfolio or diversion of cargos to better-paying markets, he is going to lose money. That’s the deal.
This is no mean feat. Such a foundational off-taker is actually so precious that any project developer with a creditworthy, solvent and professional buyer with a deep market that is also willing and able to jump on board must be considered the luckiest man on earth.
The position of the off-taker is often made worse if the project is Greenfield in a country that has never done LNG before and hence has no experience in dealing with the LNG challenge. Many potential projects are also situated in territories with very inefficient legal protection or with over-regulated, bloated bureaucracies that make developing any project there like wading in a morass.
This adds enormous uncertainties to the prospect of being the sole anchor of stability in a sea of risk. Often, the buyer will have to make very onerous arrangements which will cost him, dear, if the project shows delays. Let’s just assume for the sake of an example, the buyer acquires Use or Pay LNG receiving capacity. Pushing this further, we assume the Liquefaction project goes 2 years late with its startup date.
The regasification capacity has been contracted and must be paid. The moment when you contract those things you will not know that there will be a delay in supply and you must take it as having the supply in place and no regasification capacity to land your cargos is much worse. Same goes for shipping capacity if the contract is FOB.
Pull it the way you want it – newbie buyers meeting newbie LNG projects is a real tough deal for all involved. Plus, there will be more of those as there are regions in the world that have the gas potential for small or mid-scale plants and which will never go global in sales but rather regional because of their sizes.
Someone taking this provides a lot of comfort to a “would be project developer” so I would expect that they are treated very nicely. Strangely, that is not always the case. In fact, interested buyers are often subjected to running the gantlet – even in those oversupplied times. Project Developers still seem to believe that there is plenty of market for their scarce product.
Sellers and project developers must be aware that those customers coming on board in spite of the challenges and risks are worth gold and should be treated as such. It’s a market in the end and in any market worth the term it’s the buyer that calls the shots.
That’s a lesson energy must come around to learn – or go away as the winds of change will blast all this old posturing off the face of earth quicker than we can implement changes from the last board meeting.
Energy is a commodity – delivering to customers exactly what they want when they want it and as much as they need is the art. When your buyer takes less and gives more, he is a rare beast and those are priceless.
In recent years, we have started to see deals where the buyer simply says “the volumes will be added to X company’s global portfolio”.
This looks to me like a risk management approach, to deal with potential delays, whereby the buyer contracts volumes from a number of suppliers, knowing that some will likely be delayed.
Can this approach, combined with the ever larger market in total and spot market in particular, help to overcome the anchor buyer problem?
Likewise the US projects, divorced from a specific gas source, have lowered the risk to “liquefaction costs”.
In recent years, LNG buyers have preferred quick trading bucks to building markets as this has allowed them to pin their expensive purchasing deals onto some murky trade numbers that can always be cooked up instead of having a product placement strategy at hand when investors call. And during the high oil price times, investors were all game.
I think that most buyers have either not understood the true nature of LNG (it’s still a physical business folks) or they have wilfully turned a blind eye. Overcontracting because of potential delays smacks of jumping from the frying pan into the open fire. Prettying up presentations to board and shareholders is not a good approach to manage risk. But when times are great, stomachs are solid.
Buyers should first and foremost concentrate on their real, physical market needs and their real (not imagined) capacity to place the product acquired effectively and at a profit. Everything else is like trying to stop a meat grinder from the inside.
Regarding LNG from the US, they have given the term price risk a totally new meaning. Classical LNG projects had feed gas price as a pretty stable function of their cost stack. The gas was developed as part of the upstream resource cost and once they are sunk, they are stable. Little risk here as you know what you are messing with. US LNG plants, on the contrary, have feed gas a function of the local gas market. Imagine HH goes to USD 12 per MMBtu. Impossible?
After everything that happened last year, this word should only be served with plenty of antacids.
My pleasure Jonathan